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Don't Touch These 3 Huge Value Traps

The truth about contrarian investing.

So said the chief investment officer at a major commercial bank during a recent call on the state of the economy. With the S&P 500 down 38% in 2008, shares of even stable blue chips cratering, and investors scared witless, others are wondering whether it's time to take advantage of some great bargains.

So the urgent question is: Does buying beaten-down stocks actually lead to riches?

The shocking truthTo evaluate the merits of a contrarian approach to the market today, I recently ran a screen to discover how well a similar tactic would have worked during the last recession. I divided all 278 large-cap stocks into quintiles by performance over that period and looked at how well they did over the following five years.

Here's what I found:

Quintile

Performance, March - November 2001

Annualized Performance, November 2001 - November 2006

1

(51.3%)

6.1%

2

(25.1%)

6.5%

3

(13.4%)

9.1%

4

(3.6%)

3.9%

5

9.6%

9.2%

Total

(16.9%)

7.1%

Stocks trading on major U.S. exchanges capitalized at more than $10 billion on March 1, 2001. Data courtesy of Capital IQ, a division of Standard & Poor's.

As you can see, stocks that had been scorched the most over that blistering eight-month period actually underperformed those that had done just fine -- by 3.1 percentage points annually!

How'd that happen?Over those painful eight months, the market had correctly anticipated the value of many of these large companies and discounted them accordingly. A 50% haircut is certainly a markdown -- but not necessarily a sale, if the value of the company has been cut in half or was overvalued to begin with.

The savviest investors know that willy-nilly contrarianism isn't a sure path to riches. As the present financial saga that saw the demise of WaMu, Wachovia, Lehman Brothers, and a host of other troubled firms illustrates, companies often get punished for all the right reasons. And in those cases, their plight can be as bad as you think -- and worse.

The envelope, pleaseHere are the names of three huge companies (market caps around $10 billion or more a year ago) that are very likely to be value traps. All three have had massive declines in the past year, which make shares appear tempting to investors. However, they are also:

Heavily scrutinized large caps.

Returning among quintiles whose performance was anemic in the last recessionary go-around.

Rated with one or two stars (the lowest ratings possible) in our CAPS community.

Since we began tracking the collective intelligence of our CAPS investment community in November 2006, one- and two-star companies have fared poorly, with an average annualized loss of 11.4% and 5%, respectively.

Yes, shares of these companies have fallen dramatically, but that's because they've dealt with massive layoffs, deteriorating business units, liquidity concerns, and/or chronic free cash flow shortfalls in the face of an already ugly economic period.

Given the amount of attention these massive companies generate on Wall Street (as seen in that third column, "Analyst Coverage"), there's a strong chance that the sell-off was justified. If history is to repeat itself, thrashed large caps won't be the best stocks to buy now. If you want to profit from the recent marketwide sell-off, you need to look where others aren't.

A contrarian contrarian strategyThis time, I compared the post-recession returns of the aforementioned 278 large caps to the performance of all 1,740 small caps. I had expected some disparity in their five-year returns, but its sheer size was astounding:

Quintile

Small-Cap Performance, March - November 2001

Small-Cap Annualized Performance, November 2001 - November 2006

Large-Cap Performance, March - November 2001

Large-Cap Annualized Performance, November 2001 - November 2006

1

(53.8%)

23.7%

(51.3%)

6.1%

2

(19.8%)

16%

(25.1%)

6.5%

3

(1.4%)

14.5%

(13.4%)

9.1%

4

14.7%

14.3%

(3.6%)

3.9%

5

57.3%

13.7%

9.6%

9.2%

Total

(0.7%)

16.7%

(16.9%)

7.1%

Companies capitalized between $100 million and $2 billion versus those capitalized at more than $10 billion on March 1, 2001. Data courtesy of Capital IQ, a division of Standard & Poor's.

A small-cap contrarian approach following the last recession would have paid off handsomely, turning a $10,000 investment into nearly $30,000 in just five years. Not only did the most beaten-down small caps outperform their spared peers, but also, every quintile of small caps outperformed every quintile of large caps over the following five years.

And that last recession was no anomaly. According to T. Rowe Price, small caps have beaten large caps by nine percentage points on average over each of the past 10 recessions.

Among the most disappointing contrarian plays would have been buying $22 billion Ciena(NASDAQ:CIEN) or $28 billion JDS Uniphase(NASDAQ:JDSU) back in November 2001, when they were "on sale" for more than 70% off -- because both fell another 80% over the next five years. However, $177 million USG(NYSE:USG) and $826 million ArcelorMittal(NYSE:MT), which had fallen by a similar amount, became eight- and 35-baggers over the next five years, respectively.

In fact, every single one of the top 10 stocks since the last recession was a small cap or mid-cap. Among the very largest of those companies destined for greatness were then-$2.9 billion Blackberry maker Research In Motion and $3 billion fertilizer producer PotashCorp.

Studies have shown that over the long haul, small caps outperform larger companies. According to research from professors Fama and French, small-cap value stocks outperformed their larger counterparts 17.3% to 13.3% on average from 1956 to 2005.

That's because small caps tend to be less closely watched by big brokerage houses and the financial media, so their stock prices are more likely to behave irrationally -- and provide huge opportunities during times of turmoil.

In other words, if you want to take full advantage of all the wonderful values in the market today, you need to look into small-cap stocks.

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This article was originally published on Aug. 7, 2008. It has been updated.

Ilan Moscovitzdoesn't own shares in any of the companies mentioned in this article.USG is a Motley Fool Inside Value recommendation. The Fool has a disclosure policy.